Starwood Property Trust Inc

NYSE:STWD

Earnings Call Analysis

Starwood Earnings Highlight Diverse Business Growth

Starwood Property Trust reported strong distributable earnings (DE) with $189 million or $0.58 per share for Q4 and $663 million or $2.05 per share for the year. GAAP net income was $71 million or $0.22 per share for Q4 and $339 million or $1.07 per share for the year. The company saw significant contributions from commercial and residential lending with $1.1 billion in originations for the year, though repayments summed to $2.9 billion. Their loan portfolio ended at $15.9 billion, with adjustments for nonperforming assets and foreclosures. Charge-offs and impairments related to real estate owned (REO) properties were substantial, totaling $351 million for the year. Starwood Mortgage Capital's performance was boosted by 5 securitizations worth $467 million, representing a strong end to the year. They maintain a healthy servicing portfolio, ending the year at $98.7 billion. Notably, they achieved higher mark-to-market valuations in their residential lending portfolio and expect continued business growth in 2024.

Solid Earnings with a Note of Caution

The company reported robust distributable earnings of $189 million for the quarter, contributing to an annual total of $663 million. While the figures are strong, management cautions that this quarter's performance is not necessarily indicative of a standard run rate due to extraordinary performances in certain segments.

Commercial Lending and Loan Originations

Commercial Lending saw a busy year with new loan originations reaching $1.1 billion, while repayments totaled $905 million for the year. The portfolio ended at $2.6 billion, sustaining its health despite some downgrades in loan risk ratings.

Real Estate Owned (REO) Challenges

The company was unable to finalize the sales of significant REO assets, leading to considerable impairments. These included a $71 million impairment on a vacant building in Downtown L.A. and a $30 million impairment on a Houston office building, impacting the bottom line and reflecting the difficulties in the REO segment.

Strong Performance in Mortgage Securitization

Starwood Mortgage Capital, the company's conduit, executed five securitizations in the quarter, totaling $467 million. This impressive volume accounted for a substantial 61% of the year's total securitization activity.

Residential Lending Adapting to Market

The residential lending portfolio improved markedly with tighter spreads and lower long-term rates, leading to a positive valuation adjustment of $152 million, somewhat neutralized by a $99 million negative hedge mark.

Caution in Loan Reserves and Impairments

A cautious approach saw a $28 million increase in the general CECL reserve, primarily due to the U.S. office segment. Real estate owned impairments also rose by $101 million. These reserves together represent 3% of the loan portfolio, signaling prudence in anticipation of potential future loan losses.

Property Segment and Value Add

The property segment realized a fair value increase of $18 million, determined through an independent annual appraisal, reinforcing the underlying value creation within this portfolio.

2024 Outlook and Strategic Positioning

In preparation for the future, the company has halved office exposure since 2019 and trimmed future funding obligations. The expectation is to maintain ample liquidity to address corporate debt maturities in December 2024 and March 2025, while continuing to invest cautiously in 2024. Management aims to replace high-cost bank lines with more favorable unsecured debt as spreads decline, potentially arguing for a credit rating upgrade due to increased unsecured debt percentage on the balance sheet.

Earnings Call Transcript 2023-Q4

[Operator]

Greetings. Welcome to Starwood Property Trust Fourth Quarter and Full Year 2023 Earnings Call. [Operator Instructions] Please note, this conference is being recorded.

At this time, I'll hand the conference over to Zach Tanenbaum, Head of Investor Relations. Zach, you may now begin.

[Zachary Tanenbaum, executive]

Thank you, operator. Good morning, and welcome to Starwood Property Trust Earnings Call. This morning, the company released its financial results for the quarter and year ended December 31, 2023, filed its Form 10-K with the Securities and Exchange Commission, and posted its earnings supplement to its website. These documents are available on the Investor Relations section of the company's website at www.starwoodpropertytrust.com.

Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute forward-looking statements. These statements are based on management's current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. I refer you to the company's filings made with the SEC for a more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The company undertakes no duty to update any forward-looking statements that may be made during the course of this call.

Additionally, certain non-GAAP financial measures will be discussed on this conference call. A presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC at www.sec.gov.

Joining me on the call today are Barry Sternlicht, the company's Chairman and Chief Executive Officer; Jeff DiModica, the company's President; and Rina Paniry, the company's Chief Financial Officer.

With that, I'm now going to turn the call over to Rina.

[Rina Paniry, executive]

Thank you, Zach, and good morning, everyone. Starting with our results. We reported distributable earnings or DE of $189 million or $0.58 per share for the quarter, and $663 million or $2.05 for the year. The strong quarter was highlighted by contributions across our businesses, although it likely does not constitute a run rate.

We had outsized performance from our conduit this quarter after a slow start to the year and also had $0.04 of earnings related to commercial lending repayments, including prepaid penalties and foreign currency hedge on line.

GAAP net income was $71 million or $0.22 per share for the quarter, and $339 million or $1.07 per share for the year. GAAP book value per share ended the year at $19.95, with undepreciated book value at $20.93. These metrics were impacted by an increase in our commercial lending reserves, including increases in our general CECL reserve, charge-offs and impairments related to REO properties totaling $129 million and $351 million for the quarter and year.

I will begin my segment discussion with Commercial and Residential Lending, which contributed DE of $205 million for the quarter or $0.63 per share. In Commercial Lending, we originated $707 million of loans, which brings our full year originations to $1.1 billion. Repayments of $815 million in the quarter and $2.9 billion in the year outpaced fundings of $664 million and $1.7 billion.

Our portfolio of predominantly senior secured first mortgage loans ended the year at $15.9 billion, with a weighted average risk rating of 2.9. This is consistent with last quarter despite downgrades of 4 loans, totaling 502 million to a 4 risk rating, of which 450 million were U.S. office. Offsetting this were upgrades from a 4 to a 3 risk rating, totaling 197 million, including a $159 million formerly vacant office loan in Brooklyn that was converted to multifamily and brought current by the sponsor.

In the quarter, we had 1 new foreclosure on a $61 million multifamily loan, and 1 new nonaccrual related to a $124 million office loan. Both loans were 5 rated and will be covered in Jeff's remarks.

Last quarter, I mentioned that our CECL balance doesn't tell the whole story of our asset reserves because some of our loans have been moved to REO, and some loans that are still on our balance sheet have recorded charge-offs. Although these have already been taken out of GAAP book value, neither of these appear in our CECL reserve. However, they are really no different than a specific reserve, just on another financial statement line.

In the quarter, our general CECL reserve increased by $28 million to a balance of $307 million, of which 74% relates to U.S. office, while REO impairments increased by $101 million to a balance of $172 million. Together, these reserves represent 3% of our lending portfolio.

To clarify the REO component of this, I want to briefly discuss the GAAP accounting model. Once an asset is transferred into REO, it follows property accounting. This means, it is held at amortized cost unless events or changes in circumstances indicate that its carrying amount may not be recoverable. We encountered these indicators on 2 previously foreclosed assets, which were either under written agreement or active discussion to be sold at our basis to unrelated third parties. Both transactions failed to materialize.

The first asset is our vacant building in Downtown L.A. that has a DE basis of $245 million. Because our current quarter negotiations to sell this asset were ultimately unsuccessful, we commissioned an updated appraisal, which resulted in an incremental $71 million GAAP impairment.

The second asset is our office building in Houston that has a DE basis of $126 million. After an LOI at our basis was terminated last quarter, we engaged an updated appraisal. Shortly thereafter, we entered into an LOI with another unrelated third party to sell the property at a price lower than our basis. That transaction was also unsuccessful. Although the appraisal indicated full recovery of our basis, we conservatively utilized the value implied by the most recent LOI to determine our GAAP impairment of $30 million. You will find these impairments presented in the other loss common net line in our GAAP P&L, and reflected as a reduction of the property's common net line in our balance sheet.

Next, I will discuss our residential lending business. Our on-balance sheet loan portfolio ended the year at $2.6 billion, including $916 million of agency loans. The loans in this portfolio continued to repay at par with $60 million of repayments during the quarter and $239 million year-to-date.

Given tighter spreads and a decline in longer rates, the mark-to-market on our portfolio improved by $152 million this quarter, partially offset by a negative hedge mark of $99 million, and our $450 million retained RMBS portfolio, lower prepay speeds continued to benefit this book with tighter spreads contributing to a positive $6 million mark-to-market.

Next, I will discuss our Property segment, which contributed $22 million of DE or $0.07 per share to the quarter. Of this amount, $13 million came from our Florida affordable housing fund. For GAAP purposes, we recorded an unrealized fair value increase related to this portfolio of $18 million in the quarter, net of noncontrolling interest. The value was determined by an independent appraisal, which we are required to obtain annually.

Turning to Investing and Servicing. This segment contributed DE of $33 million or $0.10 per share to the quarter. Our conduit, Starwood Mortgage Capital, helped drive our outperformance in the quarter, completing 5 securitizations, totaling $467 million, which represented 61% of their securitization volume for the year. We expect to continue seeing higher volumes from this business in 2024 as loan maturities and originations picked up. The year is off to a good start, with 2 securitizations totaling $118 million of loans completed in January.

In our special servicer, fees increased to $14 million in the quarter due to $500 million of loan resolutions. These resolutions were offset by $1 billion of new transfers into active servicing, nearly 2/3 of which were office or contained an office component.

Our named servicing portfolio ended the year at $98.7 billion, driven by $1.8 billion of new servicing assignments in the quarter, and $6.7 billion during the year.

And on the segment's property portfolio, we sold [indiscernible] asset in the quarter for $32 million. Since inception of this portfolio, we have sold 30 assets, totaling $412 million for DE gains of $144 million, demonstrating our ability to successfully acquire and reposition transitional real estate.

Concluding my business segment discussion is our Infrastructure Lending segment, which contributed DE of $23 million or $0.07 per share to the quarter. We continued to see strong investing this quarter with $425 million of new loan commitments, bringing our total for the year to $1.1 billion, its highest level since we acquired this business in 2018.

Repayments totaled $182 million for the quarter, and $905 million for the year, with the portfolio ending the year at a balance of $2.6 billion.

And finally, this morning, I will address our liquidity and capitalization. Our leverage continues to remain low with an adjusted debt to undepreciated equity ratio of just 2.47x. This reflects the fourth quarter repayment of our $300 million unsecured notes, which leaves us with no corporate debt maturities until December 31, 2024, when our $400 million unsecured notes mature.

In addition to low leverage, our liquidity position remains strong today at $1.2 billion. This does not include liquidity that could be generated through sales of assets in our Property segment or debt capacity that we have via the unsecured and term loan B market.

With that, I'll turn the call over to Jeff.

[Jeffrey Dimodica, executive]

Thanks, Rina. Our industry originated more loans from late 2020 through early 2022 than any other period in our history, thus creating a significant amount of initial maturities in late 2024 and early 2025. Fortunately, the 10-year treasury yield fell 100 basis points in the fourth quarter, and forward SOFR made a similar move and is now pricing at a 175 basis point reduction to 3.6% in 2025.

While this more optimistic interest rate environment has reduced tail risk for the 90% of our assets that are not loans on U.S. office, the rate move to date has not been large enough to materially change U.S. office market outcomes as office pricing also has to deal with lower net effective rents, the persistence of work from home and a lack of liquidity in the office lending markets.

Being managed by one of the largest real estate private equity firms in the world, asset management has always been a hallmark of our company's outperformance, and our entire team is focused on asset management today. We have had net realized gains on REO to date, but with lenders continuing to move away from the office sector, we have had multiple asset sales fall out of contract at our basis in recent months, and we are evaluating alternate disposition plans.

Rather than wait for a better option that may not come, we have uniquely moved over $600 million of loans into REO to date. These assets are now the focus of our asset management team and our goal is to maximize shareholder value. We will continue to evaluate options, including adding capital and repositioning assets rather than quickly selling into a distressed market with seller financing that could put a longer-term drag on earnings.

Rina mentioned, we placed a $124 million, 5 rated office loan in Arlington, Virginia on nonaccrual in the quarter. As you likely know, Greater D.C. has been the hardest hit by work from home, with the majority of government employees still at home 4 years after COVID, making this long-term stable and consistent office market one of the most difficult to underwrite today. This loan went into payment default in the quarter, and we are evaluating foreclosing in the coming quarters to either reposition or sell assets.

The property is operationally cash flow positive and at 4.5 years of remaining [indiscernible]. We will continue to look for accretive leasing, while we decide on the right time to potentially sell the asset, assuming we take title.

Rina also mentioned we foreclosed on our first multifamily loan in the quarter, a $61 million loan on a recently built multi in the Pacific Northwest that has been slow to reach stabilized occupancy. If we choose to sell this asset, we expect to see a return of our basis in 2024.

This asset is systemic of what we expect to see as the cycle moves to its next phase under capitalized borrowers who lack the staying power to protect assets until stabilization will be replaced by large balance sheet with staying power like ours or we will move the assets to the substantial pools of third-party capital that have been raised to recapitalize them.

The majority of our industry's multifamily loans have stabilized debt yields above 6%, and assuming today's forward curve is correct, we expect most of these will be able to refinance at our loan proceeds or as sponsors who will see value in paying down their debt, buying interest rate caps and replenishing reserves to qualify for extensions.

Most of these borrowers bought new interest rate caps in 2022 or 2023 that were more expensive than they are today. So we expect them to do the same to qualify for extensions in 2024. Should they choose not to protect what is essentially a 6-plus cap multifamily asset and should we choose to foreclose, we expect to recover our basis or more if interest rates and cap rates continue to normalize going forward.

As I just mentioned, we have profitably bridged assets to stabilization in the past. We will be patient where we see long-term investment opportunities and believe there is significant liquidity at or near our basis on lease-up multifamily assets where we don't choose to stay in them longer term.

Looking at our broader CRE lending portfolio, we proactively cut our office exposure in half since 2019, while also reducing our construction and future funding exposure by half. Pro forma for a data center loan that paid off in full last week, our future funding obligations sell to $800 million net of senior financing, a fraction of our company's typical and historic level. Less future funding obligations will allow us to maintain our significant liquidity as we look to pay off corporate debt maturities in December 2024 and March 2025.

While we expect to refinance these in the capital markets, should we choose not to, we have ample liquidity to repay them with cash while maintaining a significant liquidity cushion. As Rina said, we received $4.8 billion of repayments in 2023, and we funded $3.6 billion of loans. Our projected excess liquidity will allow us to continue to invest accretively in 2024, albeit still at a measured pace.

We created this diversified company and have maintained low leverage over the years to the benefit of both our equity and debt investors. You've heard us say, we would like to be investment grade in the future. And to do that, we need to maintain our lower leverage and increase the amount of unsecured debt on our balance sheet as a percentage of total debt.

The high-yield index hit 600 basis points over treasuries in the fall of 2022 and is at 355 basis points today. Our borrowing spreads have followed that trend. As we continued to lend in every quarter since COVID, we made many loans at higher asset spreads and finance them with nearly $2 billion of higher-cost bank lines, while still creating accretive shareholder returns. Should unsecured borrowing spreads continue to fall, we will be in a position to replace these expensive, really prepayable bank lines in the unsecured debt markets at little to no cost to us for the first time in our history.

Pro forma for that debt replacement strategy, we would be in position to argue for a potential ratings upgrade as our unsecured debt percentage would increase substantially. I will note that our BB and BB plus corporate ratings were affirmed by all 3 rating agencies in the higher rate environment we faced in 2023.

As I just mentioned, the vast majority of our borrowings today are noncorporate debt. Our focus has always been on maintaining significant covenant ratio cushion in those facilities. We have a fixed charge covenant ratio, defined as EBITDA over cash interest expense of 1.4x on our non-corporate debt, as do most of our peers. Our lower leverage model creates lower interest expense, which in turn gives us significant flexibility under this and our other debt covenants.

Our FCCR today sits at 1.8x, giving us billions of dollars of additional debt capacity should we choose to use it and over $100 million of EBITDA cushion, leaving us with tremendous flexibility on how to grow or further optimize the right side of our balance sheet going forward.

We are addressing 2 opportunities created by the noticeable pullback of regional banks in middle market CRE lending. Our Starwood Solutions business is now up and running, and we believe a significant portion of the demand for valuation and workout services will come from the regional banking system. We also hired a seasoned CRE professional to create a middle market lending vertical at STWD for the first time to focus on the $15 million to $50 million loan size that regional banks historically dominated, and we have historically not participated in.

This smaller balanced loans segment offers premium unlevered yields, and we believe this increased ROE will be very accretive to shareholders in the coming years, albeit on less equity than in our large loan business.

Moving to our energy infrastructure lending business. 2023 marks our highest origination volume year since we purchased the business from General Electric in 2018. We wrote $1.1 billion in loans in 2023, which is the same amount as we wrote in our core business, CRE lending. We continue to like the attractive risk reward of power and midstream assets. And with funding costs remaining steady, we were, again, able to earn above historic levered returns in this segment in 2023, and we expect to continue to grow this segment in 2024.

Finally, our low leverage and uniquely diversified business model that was built to outperform in volatile markets has allowed STWD to earn the only positive total return in our sector since the beginning of COVID.

With that, I will turn the call to Barry.

[Barry Sternlicht, executive]

Thanks, Jeff. Thanks, Rina, and thanks, Zack, and good morning, everyone.

I wrote a colorful quote in our press release, but I do think it's worth noting that the real estate industry just has a balance sheet crisis. It's affected nearly every class -- every asset class, maybe safe data centers. But even there, yields on costs have to rise to reflect the increased cost of capital. And the real estate distribution caused this economic situation. We were just an unintended consequence. But a material consequence for cities and municipalities as values drop and real estate values -- real estate taxes based on values will come down and cities and municipalities won't be able to fund their police fireman, waste management and schools.

So the Fed has 3 victims of their current policy, and we're headed towards 300 basis point real rates unless they were lent. The first is the government themselves saying 5%, 5.3% on $33 trillion, 1/3 of which rolls over this year.

The second are the regional banks, which cannot stay solvent with these current interest rates, with $1.9 trillion of real estate exposure, not to mention the mark-to-market or not required mark-to-market on the securities book. And the third would be probably the entire real estate industry in the complex.

People talk to me about the level of rates in the 4.3%, 10 years is not an issue. We all could adjust to it, we've adjusted to it before. But simply the pace of the increase, the rapid increase and, of course, the statements that we were going to stay lower longer in December of '21. And then actually easing into May of '22, and the fact that the Fed relied on stale data or very delayed data for 1/3 of its CPI, so when rents were flying, they showed no inflation. And now their rents are falling, they're still showing a significant increase in rents in the apartment and residential sector.

So it's not clear why we use data for residential that's not current when we use current data for energy and for food. It would take a minute for the Fed to call Fannie and Freddie and find out what's really happening in the apartment market, in the residential markets. They have more data than you want on earth. And they would see that they're running the economy and the global markets and causing recession, both in Japan and now in parts of Europe. Based on the other governments, they need to increase rates to defend their currencies because of the Fed's actions.

And when people allaud the current Fed for their policies, they don't pay attention to the fact that $6 trillion of stimulus was hit the shelves or hit pocket books as the things on the shelves disappeared. And so inflation was simply too much money chasing too few goods. And that it was going to correct on its own, which what had the supply chains obviously fixed, and consumers are now running out of the $6 trillion.

And the economy continues to be healthy -- healthier than thinking most anyone thought because of fiscal spending, and they cannot impact the economy with -- or the job market with interest rates anymore. When the half of your labor force is in health care, in education and local governments, as you saw last month, 107,000 health care jobs have created. They're going to continue to be created despite anything the government does other than crushing what's left of the economy, which would probably be the retail sector or the services sector. And that would include layoffs at store, in the hotels, airlines, Goldman Sachs, all the investment banks, all the banks, that can only do with a real recession. It's -- you're going to have to be careful to land this plane softly. And the government spending continues at pace, and we're not getting construction job losses that we expected.

Now, all the asset classes in real estate have been impacted differently. You're going to see and we continue to see a wave of multifamily assets complete there, and in the total number of units being completed is not out of line between single-family and apartments, but it shifted from 40-60 apartments, single-family to 60-40 apartment single-family. And that -- the good news is the markets are absorbing this, but it's causing market rents or existing rents to weekend, which is why we've been some confident inflation will come down and it will show up eventually in the CPI numbers, is it -- is it 1/3 of CPI.

That wave of new supply fortunately will die at the end of -- middle of '25, almost all those units will be complete and we'd expect to see rent growth accelerate again in the apartment markets.

I think for that reason, with 40% of our lending book in the apartment space, we would like to get these assets back. We will make more money if we actually -- if our borrowers give us these assets back, our loans are 65% of typically of cost. We're buying it at -- our basis would be super attractive. And the best we can do when we lend is get our capital back in our coupons while we have [indiscernible] opportunity with well-positioned assets to make more money, frankly, if they were to fall into our lap.

We've only had 1 default. And as mentioned in the call, we would expect to sell it at the basis of the loan very shortly.

But while there's light at the end of the tunnel because all of us believe, I believe -- I think all of us believe, most -- all of us believe that the Fed has done hiking, when they lower rates is going to be very interesting. And I'm pretty sure they're aware of the consequences and the teetering side of regional banks, the losses that you cannot exactly track, both in office, resi and even in the industrial markets, which were being acquired at yields that are no longer market passing yields.

So there is strain in the real estate markets. We are in the ship. We are in the boat. We are navigating these waters. We're going to take some losses. We're going to be okay. We have set ourself -- the company up with a massive amount of liquidity, the decline in future funding that Jeff mentioned, $800 million of net funding -- of future funding calls on us, it's really 60% construction, all of which is fine. And 40% is called good news, it's -- you committed to do a tenant improvement or lease a building. And those will happen if they happen, the borrower may not actually even call the capital because he's worried that the money that goes into TI, the building may not be worse that when -- or when -- if he goes and heads and puts these tenants in these buildings.

So I think we've certainly got a very diversified business model. it's -- we're delighted that we can invest incremental capital in the energy space right now, which is providing a very attractive double-digit yields. And we continue to build that book. It's actually the biggest it's ever been, I think, since we started. We bought that business from, gee, years ago.

I do -- it is notable about the light at the end of the tunnel, the conduit markets are strong, and we've had a good launch this quarter, the credit spreads are coming in, the market is anticipating rates coming down, and AAAs have come in probably 60, 70 basis points across the board just in the last 3 months. That's the first sign that the markets are healing. And the CMS markets are pretty wide open to act as a new exit strategy for borrowers who are trying to repay loans.

I hear to [indiscernible], it was really just the existing lender. But now, if the asset is stable and secure and it's in probably one of the favorite asset groups, but even office is finding its way into conduits and securitizations and now like at 16% to 20% of the securitization might have office in its portfolio.

So you really are playing hand-to-hand combat, in our case, partnering with our borrowers and figuring out workable solutions, using our entire organization here and in Europe to get through what is a challenging period. But I think we feel pretty comfortable that our dividend will be secure, very comfortable. Our dividend will be secured for the foreseeable future. And we just had a really significant payoff of a loan, a very large loan in the book. And there are some other things that are mentioned in Jeff's and Rina's comments that will provide additional liquidity to us. And we're very cognizant of getting through all of this.

Sometimes, you don't really know. We'll be taking -- I've visited recently an asset we took back in Washington, D.C., [indiscernible], a beautiful building. It's an -- [indiscernible], we announced an equity our borrowers have lost, unfortunately. But in that case, we will reposition that office building as the apartment building. It's actually quite beautiful. And we'll just take a little bit of capital, but it will come out of our book.

And when I look at the company, we have almost $1 billion of assets that aren't earning much, if anything. So that's additional earnings power as we've rationalized and redeploy the capital into things that could earn a substantial return on investment.

This is actually as good a time to be a lender, maybe 2009 when we started the company, but we have to be very careful how much often we go, and we are still investing. Unlike many of our peers, we are actually still finding opportunities and playing here and there, taking through the opportunities that the team sees and it's -- that is good news for us. And we have an office loan in Europe that is 100% leased. It's going to repay. We know what we repay. And so our office exposure will continue to drop. You think the biggest one, our biggest office one in Europe.

So the complexion of the portfolio is solid. We have a $15 billion loan book against the $25 billion, $27 billion, $26 million asset base. So we are not just a commercial mortgage lender today, we have other businesses that are higher ROE businesses, that are continuing to accelerate, like the special servicer who is a -- you just wonder how many of these office buildings are going to wind up in [indiscernible]. But I would say a lot of them.

And you will see a lot of people still have caps on their loans, and they can cover debt service, but they cannot refinance. And if anybody thinks that the real estate markets have prepared themselves, and that wouldn't be the case just yet. Although we do believe that, of course, if the Fed lowers rates where we expect 150 basis points real rates instead of 300 basis points of real rates, this will get much better faster in many asset classes that we're exposed to.

The office markets in the U.S. are unique. They're not like the European office markets. I recently returned from Germany, where rents were up 5% to 15% last year, and pretty much everything we've done in the construction has leased or preleased, Same is true in the Middle East and Asia.

So this is a U.S. phenomenon really only. And there in the U.S., you have a bifurcation between the really good buildings, which actually remain full and are holding your tenants in the B and C. So I think U.S. office is going to look a lot like the mall market. The best malls are full, tenants scramble to get in them. They have pricing power, and the B and C malls are going away at the [indiscernible]. And many of these generic buildings, we'll probably have to find alternative use, which might include tearing them down.

So the team has dug in. Everyone is in their seats where the Board is supportive and creative. We started Starwood Solutions, and I hope it becomes a meaningful contributor to our earnings growth going forward. And we thank you for your support.

With that, we'll take any questions, I guess.

[Operator]

[Operator Instructions] First question comes from Sarah Barcomb with BTIG.

[Sarah Barcomb, analyst]

I'm wondering if you can talk a bit more about your new focus on middle market lending strategy. What's driving the decision to enter that market? Is it mostly a function of regional banks backing away or maybe reduce takeout liquidity on the large balance side? And would you consider looking at an existing middle market loan portfolio or primarily focused on new originations?

[Barry Sternlicht, executive]

We definitely look at existing books if they were, I mean, they have to be performing. We're not really in the NPL business here. It's just -- it's really hard to run a public company because you don't have any earnings until you can restructure the loan, and that -- it may not be much return on [indiscernible].

As far as middle market, if you look at the pyramid of opportunities in the world, it's a pyramid that the biggest deals, over $1 billion deals, which we've written loans as large as $800 million. There are not that many of those. And today, there are not many large transactions being done. And most of our opportunities are [ refis ], $160 million of multi loan. Those are the kinds of things you see at the moment, there are not any really giant transactions being financed, but -- and most of those will probably get done in the CMBS markets right now.

So in terms of opportunity, there are the best opportunities in the middle market and the smaller loans, which have been cleared out by the regional banks, which are not lending.

So recently in 2 different situations, we went out on assets we own, not in the REIT, but in the Starwood opportunity funds and 1 was an office building [indiscernible], in Tennessee. The other 1 was a hotel in the Midwestern state. And then at 128 books and you get 4 letters of intent and they're all from debt funds at 500 over.

So we want to play in those markets. And the gentleman we hired to do that is actually sitting at the back. Say hi, guys.

[Unknown Executive]

Hi, guys.

[Jeffrey Dimodica, executive]

That's [indiscernible] joined us from [ Stellar ]. He was at Citi and Wells as a banker before that. And after [ Wharton ], he spent 9 years, I guess, at [ Stellar ] running. There are investments on both the debt and equity side, and we're super happy to have joining us this week. So we'll be a few work in progress.

[Barry Sternlicht, executive]

It's just another cylinder. It's obviously in the same sector, but it's a totally different scale asset. If we can build a giant book, that's a couple of billion of dollars of mid-market loans [indiscernible].

[Jeffrey Dimodica, executive]

Barry gave you the reasons why we're unlikely to buy a portfolio of loans. We like current loans. We don't want to bring in 4s and 5s, and we like current income.

So as we've looked at that, we've also talked to probably 3 or 4 different middle market lenders about us buying a team, partnering with the team. We looked at a lot of different ways to do this. And ultimately, we decided with the data we have, with the infrastructure we have, that it made more sense to build this internally. And we realize that these are going to be smaller loans. We're not going to have 75-page investment committee decks on smaller loans. So we're working on ways to scale this business, using [indiscernible] resources and other that will allow us to scrape data and potentially asset management and underwrite, but they'll still go through our credit process as Starwood Property Trust.

The hardest thing for us over the years on this is been deciding how can we put the same amount of credit attention. We have a Chief Credit Officer. Many of our peers don't. We have a separate underwriting function, 18 people that do nothing but underwrite loans and bring them through investment committee for us. Our originators don't do that, at most other shops, that's an originator does. They take it through fruition. Our credit process is very bank-like. Barry set it up that way in 2009. We've never changed from that. We don't intend to change from that. And we needed to find a way to be able to do this at the right cost, but we think it's a very large market, and we think it prices better than the large loan business. So we will earn a higher return on less dollars and hope that we can build it. So then if there's brokers, anybody, borrowers, please give us a call. It's a marketing call.

[Operator]

Next question, Stephen Laws with Raymond James.

[Stephen Laws, analyst]

Two questions this morning. First, regarding Woodstar. Rina, I think in your prepared remarks, you mentioned it was a third-party appraisal that drove the valuation increase. But can you talk a bit about the cap rate where that asset is today? What gives you comfort in that? And any color on rent bumps that we expect to see in the second quarter?

[Jeffrey Dimodica, executive]

Yes, Stephen, thanks a lot. Rina did mention that we're required to get an appraisal in the funds that, that is in. And so we got our required appraisal that came in a couple of months ago. I think you asked about cap rate. It's basically a 4.5% in-place asset level cap rate. We expect that forward income as we look to May, when rents get given to us by the state of Florida again. We expect them to be higher. They're based on, formulaically, on median income and CPI, both were higher this year. We expect them to be not insignificantly higher.

If you remember, last year, we had a 3.8% holdback on our rents that we were allowed to put through as it's the first time in the State of Florida did that. They wanted to make sure that we weren't increasing rents at a pace that tenants couldn't keep up with. We're okay with that. We know we're going to get the money down the line.

So we expect to be able to add 38% incremental onto the median income and CPI. So this year will probably be another year that we will be a fairly high number. And because of that, we will probably get capped again. And we'll...

[Barry Sternlicht, executive]

Just to figure that up, they allowed, I think, an 8% increase. By formula, it was like 11.3%, and the 3.8% or whatever, that rolls over to the next year. So we would think the rent -- pretty certain, the rent growth of between 5% and 10%. And again, if it's above 10%, they're not going to let you take it. So it will roll into 25%.

So that's not so usual as -- let me -- hold on a second. This is a very unusual asset class. You're 100% full. You're effectively full. The only vacancy you have is turning of units because your rents are 30%, 40% below market rents.

So you run 97%. Actually, we have 1 issue with squatters in 1 city Florida. But other than that, you're full and rents can't go down. So it's a totally different animal than market rate apartments, which are obviously softening in many markets. In some cases, rents are negative.

New leases in some markets, given the supplier going negative. So you can go read Rick Campos' comments to [ Camden Property Trust or [indiscernible] and you get a very good sense of what's going on. Maybe the Fed should release these reports and adjust their numbers. They maybe they should [ fire ] 400 PhDs and get 2 people with a computer making full rents from rent.com and have 1 million data points.

[Jeffrey Dimodica, executive]

Yes, Stephen, it's interesting. We are more -- our rents -- even though our rents have gone up significantly, and that's driven the value increase that you've seen on our financials, our rents are more below market today than they were when we bought the portfolio. So market rents have gone up by more. And to Barry's point, to being 99% leased, that sort of almost ensures it.

So as we look to April, May, when we'll get more information on the forward rents, as I look at that in-place cap rate, the asset level cap rate that I quoted before, you can almost think of that as a mid to high 4s cap rate against where they see forward income coming at the -- with the increases that we have coming.

[Barry Sternlicht, executive]

But again, this sector -- the multi isn't impacted by new supply. Sadly, all of the 80/20 [indiscernible] deals. I mean, there's no affordable housing, not enough to be built. So you have no issues of supply in affordable. And that's one of the reasons for the differentiation to cap rate between what I'd say a market clearing price today would be for market multi and affordable housing project.

[Stephen Laws, analyst]

Yes. As a follow-up, I wanted to touch on -- I heard recently, you bought an $80 million loan out of a CLO. Can you maybe talk about that? How you think about managing collateral in your CLOs and kind of what drove that decision?

[Jeffrey Dimodica, executive]

You're good. That just came out deep into the reports in the last week or two, but I appreciate the call. CLOs for us have always been an opportunistic financing. A notes are our favorite financing. They have no recourse, they're term. They have no credit marks, and they have no crop.

CLO is our second favorite form of financing. We get rid of the mark, the ability to credit mark and we get rid of the recourse. And we've issued 3 CLOs to date, $3.375 billion in total of CLOs. And they've come in general, it spreads slightly inside, even with our issuing costs, slightly inside where our bank repo financing costs were and at slightly higher advance rates. That makes them very accretive to returns. And one of the things that makes them continually accretive for a longer period of time is as loans pay off that you reinvest in those CLOs.

We've done that, I think, $1.1 billion of reinvestments on 53 or 56 different loans over the life of these 3 CLOs that we have, which has been very good for us. But we think of the CLO as a partnership with our bond holders. We intend to issue again when it's accretive. But again, it will be opportunistic.

We've said before that having a CLO finance only public company is more of a trade and not a business. The CLO market does go away at times. We've seen it go away in the last year from being accretive to repo. And when it is accretive, again, we will be back in the market. As part of being a partnership with our bondholders, and they allow us to reinvest, and that allows us to keep a lower cost of funds because we're not paying down the bonds sequentially, starting with AAA, which would increase our cost of funds. So reinvestment is good for us.

What's good for them is being partnered with a partner like us who is willing and able to buy loans out when there is a default. We don't want to have defaulted loans in there and have to work them out within. And we've said for a long time that everyone has the desire to buy loans out. We'll see in difficult times who has the ability to buy loans out. So yes, we did buy a $81 million loan out of the CLO. That CLO was out of reinvestment. So that is costing us a higher cost of funds, by virtue of that $81 million, we'll pay off senior bonds.

But we want this to be a partnership with our bondholders. We want them to see that we're willing to step up. And when we come back to the market, we expect better pricing than the market because we've continued to do that. I think we bought $260 million of loans out of CLOs. I'm getting away from the reinvestments now. But we bought $260 million of loans out of these CLOs, which I think is very good for our platform.

[Operator]

Our next question comes from Rick Shane with JPMorgan.

[Richard Shane, analyst]

Jeff, just one quick clarification. The $260 million, that was in the fourth quarter or that was for '23?

[Jeffrey Dimodica, executive]

No, that's life to date. In the quarter, the -- if you go into [indiscernible], you can see that we bought an $81 million senior office loan up.

[Richard Shane, analyst]

Got it. Okay. Look, I'd like to talk a little bit about 2 aspects of the -- well, first, REO. You guys have basically indicated that you are positioned to be long-term holders of REO and think that you're good operators and that this mitigates to some extent the charge-off risk associated with it.

As we think about distributable earnings, is there enough cash flow off of those assets to come close to replacing what you were generating as lenders?

[Jeffrey Dimodica, executive]

Yes. It's a really interesting question. So a lot of the things that you're seeing go into our higher risk rated buckets, even the office, generally have 4 to 6 debt yields. They just don't have the 7 or 8 debt yield you might need to escape. So 4 to 6 debt yield means that there is cash after operating the -- after operating the office building, there is cash to distribute. It's just not quite enough to distribute to cover a new interest -- full interest loan.

So there is cash flow coming out. So the drag is less because of that, Rick. So we will take that into account. We certainly -- we've talked about a few assets that we would like to move on from because they don't pay current. We do care a lot about current income. So if an asset is sort of too big of a drag and it's more of an opportunity fund play where it's not going to pay something for an awful long time, that will be difficult on DE in the shorter run. I think you would only see us doing that if we feel really comfortable with our ability to cover our dividend away from that. If we started to feel like we were uncomfortable being able to cover it, we would probably move on those assets more quickly, and we wouldn't have the room. But fortunately, we've had some cushion in earnings, and we expect to have some cushion now so we'll be able to be flexible and choose what we want to keep longer and what we want.

So I think we've seen some numbers this week on percentages of assets in REO. And you just asked -- excuse me, in nonaccrual, and you just asked about REO. Between nonaccrual and REO, it's only 3.4% of our assets. So not a terrible burden yet. If you think -- as long as you cover the dividend by [indiscernible], and they don't even kick off any cash flow to cover the dividend. I just made a scenario where they do kick off some cash flow, and we cover the dividend historically by more than 3.4%.

So we don't see it as a major drag to distribute earnings, but it could become one. If the cycle continues, it could become one, if rates don't follow the forward curve, and we are aware and at our battle stations that this could get more difficult. But today, we feel okay about it.

[Barry Sternlicht, executive]

Just to quickly sum up, I mean, they're all different, some of these assets. And we get a multi [indiscernible], it's probably yielding 6% or 7% to 6.5%. So -- but that's kind of where we would expect to get assets back. And if the cap rates for multis are [ not ] 6.5% today.

So having said that, if it's a single asset partnership that borrowed against us, they may not have access to money. They may just don't have the capital or the investors don't want to put the money up. But again, that we would love to get those back.

The challenging assets would be the office buildings, like 1200 K Street, which I think we have the capability and it's now unlevered on our books. We can borrow the money to renovate and turn it into an apartment. That will just take a couple of years to go through the development process. Or we bring in a partner, he either buys it for us, we [indiscernible] with him. He puts up the money to renovate it, and we just establish it at base property value and we go 50-50 or something like that.

So we have a lot of flexibility. I mean, one of our loans that we know is -- I believe is money good. It's the American Dream Mall, which has had quite a long history. But I think we're probably $0.25 or $0.30 of construction costs on that asset, and it is ramping. It's burning through its free rent. The theme park is doing really well. I think it's making like $90 million of EBITDA.

So just looking -- so we just got paid.

[Jeffrey Dimodica, executive]

90% of our original underwrite.

[Barry Sternlicht, executive]

Right. And we just got paid $50 million of the principal that's got paid down because we have cross-collateralization with another asset he has, another major mall, which did a CMBS transaction and funded $50 million to us for a base, for accounting like $0.69 or something like that.

So -- and I actually think we have a chance of getting a lot of money back. So there's upsides, too, to our marks, and it's going to be all over the place. It's a little hard to figure out. In one situation, one of our borrowers had $400 million against the $400 million loan or half of their costs. And we do think that we are expecting them to walk [indiscernible] into household named borrowers.

So that's a fairly significant hit to them. We don't want the building back. It's an office building. But if we get it back, that will be creative. The good news is we'll take the basis down appropriately, and it will be [indiscernible] guide.

[Operator]

Next question, Don Fandetti with Wells Fargo.

[Donald Fandetti, analyst]

Jeff, the conduit volume was up this quarter. Can you talk a little bit about gain on sale margins on that production relative to normalized? And is this like a 1 to 2 quarter type opportunistic? Or could we see elevated levels for more of a mini secular type?

[Jeffrey Dimodica, executive]

I have Adam Behlman in the room, who runs LNR and runs the condo business for us, so I'll turn it over to him. But I would say that we are looking at this year as a comeback year. I think 2024 will feel a lot better. We had a great fourth quarter, with the first quarter starting off really well. I'll let Adam talk about it. But we've been profitable in this business because Adam probably won't go here, pretty much every quarter since we took the business over in -- or since we took over on LNR, excuse me. And that's for a bunch of reasons.

There's a lot of reasons for that. We don't tend to do the bigger investment grade tighter loans. We tend to do smaller sized loans where you have a little bit more cushion. And we hedge interest rates, and we hedge 40% or so of the credit exposure in the loans, and that's a very expensive thing to do, but it creates consistency. So we've been really excited about having a consistent book that we think has some upside this year as we're seeing some green shoots in CMBS. But I'll turn it to Adam to discuss.

[Adam Behlman, executive]

Yes. I mean, I think you can say, look, it's going to be a volume game. I think our [indiscernible] P&L will be consistent to what we've been doing over time throughout our business within [ SMC ]. I think the big problems you saw in total, we did $760 million of [indiscernible] in 2023, we're heading to be that much earlier this year than I think that would have its tighter spreads on CMBS deals. The less opportunity for other lenders out there, we just ride the [ MBA ] conference, and we were -- the CMBS lenders of the [indiscernible].

[Barry Sternlicht, executive]

Something [indiscernible] standing.

[Adam Behlman, executive]

Yes, exactly. So it really isn't -- there's a lot of people who realize that.

[Barry Sternlicht, executive]

Not that many people at the ball.

[Adam Behlman, executive]

Right. So it was good to see that. And we're seeing it. We're getting -- our Head of Credit is bombarded, he hasn't gone home very early these days, and neither have I.

Yes. I think it's -- I'm hopeful that we're certainly not going to see what we did last year, definitely.

[Jeffrey Dimodica, executive]

So we don't really quote gain on sale, but I would say it's consistent with historic levels.

And one other thing in the CMBS market that I find interesting. We've pivoted to having a decent-sized 5-year CMBS market, and that's a newish phenomenon. We needed to get B piece buyers comfortable because it's -- they don't have a long of a period of time to accrete from a lower dollar price and a B piece on a 5 year, so they have to buy a higher dollar price B piece. So that was a little bit difficult to digest at first, but I think people are realizing there's a lot of value there.

So we look all the time at CMBS versus [indiscernible] book of transitional floating rate lending. And today, I think the CMBS market we're putting something like 275 over 5-year swaps on a fixed rate basis for sort of multis, industrials, et cetera, maybe 350 over 4 hotels. And those numbers are really consistent with where we're quoting transitional floating rate, which are 3-year loans floating with 2, 1 year extensions.

So the pricing wise, if you can get the certainty of not having to deal with that role and you have cash flow that has debt service coverage that can get you into the CMBS market. The CMBS market is very interesting for that transitional borrower who has a lot -- who has a decent amount of cash flow to go into in 5 years, where historically, they probably would have all gone into the transitional floating market because they didn't want to take 10-year debt.

So that will help volumes. They're not quite as profitable because it's a 5-year deal instead of a 10-year deal, but it will help volumes, and we think we can grow there.

[Adam Behlman, executive]

We can be a part of every securitization that takes place in the nonbanking 5 and 10-year [indiscernible]. And I'll tell you it's -- Jeff's right, it's almost 70% of the new deals out there are really 5-year origination, which is taking the place and why we're below the ball because we're kind of taking where -- what the floating rate market was. But market again, the floating rate side here is open, too, on the mid-market side. So hopefully, that's going to allow us to really capture a lot of that business.

[Barry Sternlicht, executive]

Good for borrowers to have choices, and we think they have more choices now, it's good for everybody. Thank you for the question, Don.

[Operator]

Next question Jade Rahmani with KBW.

[Jade Rahmani, analyst]

Are you seeing any projects eligible for conversion to data centers as an alternative use? This quarter, we saw a homebuilder agree to sell a vacant pizza land carried at $5 million for a whopping $180 million. So I just thought I'd ask if you're seeing any alternative use cases there?

[Jeffrey Dimodica, executive]

Wow. We have 1 asset. I'll speak to where this sort of made some sense. It's in L.A. and I'm going to quote the megawatts wrong because I'm out of my area of expertise, but I think we thought that the side of the building, it would be accretive if we get something like 90 megawatts, and we could only get 30. And the problem is they're in a downtown environment, you can't create power. You can't put a power center next to it. Barry knows this better than anybody, and it's why you're seeing a lot of data centers in place like Virginia where they can create more power.

So we could only take the power that was available on the grid to us, and there wasn't enough power available on the grid to accretively turn this into a data center, which we had hoped to do. So in areas that are infill, I think it will be more difficult in power oriented and in areas where there's more land, you can create that if you create a large enough data center, but Barry is an expert, I'm going to have to turn to him.

[Barry Sternlicht, executive]

[indiscernible] that's underutilized. So to the extent that there are, yes, it's possible. And we're the fourth largest owner of data centers now in the world privately held. And it's quite a little business there. So we probably have to do a $3 billion capital raise in STWD. These things require a lot of money. They are gigantic commitment of capital.

So yes, if we got lucky, and I was visiting a building that actually we did take back, but not read, actually our opportunity fund. And there is a substation right next to it and the fibers right there. So we could get lucky, not in the building, the building will stay a building, but we actually own the land next to the substation that's empty, it was going to be a multifamily site and maybe it will be a data center someday.

So yes, I mean, it does -- it requires the power. The land isn't worth anything other than its original use unless the power is there, and the power has to be available. So these are negotiations, utility by utility, and there's a long queue. And to some extent, the tenants can help break the queue or move around the order of the queue. But some states have made data centers a big business like Virginia, and others are catching up like Texas and California has no excess power, so California won't have any data centers for a while. But that's to the benefit of the places that do have a power.

So yes, it'd be great. I'd love to have it. And it better be lucky than good. But I don't see in any of our current assets that I just -- I actually haven't looked if there's an extra power station next to the American Dream Mall. But in Washington, the office building is on [indiscernible], no, I think our station there plus [indiscernible] the nicest-looking data center in the history of mankind. Most of these are ugly [indiscernible]. So most cities won't want them inside, they just [indiscernible] existing shell. The L.A. property would have worked. [indiscernible] A big box, big load-bearing floors, which you need for the equipment .

[Jeffrey Dimodica, executive]

You have the high level Internet .

[Barry Sternlicht, executive]

So we may not get the original basis, the asset Rina talked, we had a $250 million, $40 million book [indiscernible] down to $150 million, I think.

Yes, that puts a floor under the value because $30 million, 30 megawatts, if somebody bought it for data centers, it doesn't have to be an office building or -- and we're working on a resi conversion there.

So I just think it's a beautiful building and office downtown L.A.. This is close to [indiscernible] market in the United States.

So it's a race to the bottom, but that's certainly be in contention with San Francisco and Austin. Those are 2 really tough markets right now.

[Operator]

Yes. So our last question comes from Doug Harter with UBS.

[Douglas Harter, analyst]

Hoping you could give us an update on your casino loan in Australia, just given that there has been some news about in the -- recently?

[Jeffrey Dimodica, executive]

You mean the news about Taylor Swift stayed in the casino, that one?

So she was there last night, it's in the papers today. So we're expecting a big income pop.

[Barry Sternlicht, executive]

Yes. Earnings for 1 quarter will be great. We actually -- we obviously don't own the casinos. They are held by a name firm, and we're less than half of the capital stack at our basis. They actually own the other half of the mortgage that we own on those assets.

So they're sort of 75% of the [ cap stack ], if you will. We're 51, they're 49 in the debt and the equity. And the -- they're continuing to support the property with a recent $0.5 billion infusion to cap stack. It's a fairly significant investment of the firms.

So we're comfortable that they have the expertise and they'll straighten it out. They're using some of this money to renovate their properties, which they were -- they intended to renovate them. So they never finish that, but they are major [ domo ] assets in these markets. And we're comfortable right now that this credit is fine.

So we'll see if things change. But as you know, they're coming out of some licensing issues the prior owner had that has not been resolved as quickly as they hoped. But they are very, very supportive of the credit. So we'll see as they do -- won't have the paper as well [indiscernible] equity.

[Operator]

I would like to turn the call over to Barry for closing remarks.

[Barry Sternlicht, executive]

Thank you, everyone, for joining us. I hope we have continued reasonably good news, and I look forward to this company to go back on [ offense ]. We're all chomping at the bit more offense, not that we're not in the markets, but we are cherry picking and sitting on $1.2 billion of liquidity, and then having these nonaccrual assets, it's not the greatest position, but to be able to easily cover with the [indiscernible] dividend is certainly a very comfortable position we have. You are aware, we mentioned some of the things we're -- one of the things we're selling in the first quarter, which will close in it. So we are -- and the recent repayment of $0.5 billion of senior loan, that's the equity [indiscernible]. It put us in a really good shape through to combat this next 8 months of relenting pressure from the Fed on the complex.

So thank you, and we're excited about the future of the company.

[Operator]

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.